Executives, investors, and the media often perpetuate the idea that repurchasing shares creates more value than paying dividends does. This can’t be further from the truth. Share repurchases may increase a company’s earnings per share, but for a fairly valued company, they don’t necessarily translate into higher value than seen with dividend payments. Let’s say your company earns $100, has a P/E of 15 on core earnings, and can distribute $100 in excess cash earned as either dividends or share repurchases (exhibit):
- Dividend payments. If your company pays out dividends, its equity value will be $1,500. Shareholders will have received $100, so the total value to the shareholders will be $1,600. On a per share basis, the share price will be $15. Since each share will also have received $1 in dividends, the total value and cash per share will be $16.
- Share repurchases. If your company pays out its earnings by repurchasing shares, its equity value will be $1,500, and shareholders will have received $100. On a per share basis, for those shareholders who don’t sell, each remaining share will increase in value to $16 because of the lower share count. For an individual (remaining) share, this is economically equivalent to having a share worth $15 plus $1 from a dividend.
Note that earnings per share increase mechanically; it has nothing do to with underlying value creation. If your company pays out a dividend, shareholders retain their shares and receive cash. If your company repurchases shares, the selling shareholders receive cash, and the remaining shareholders have shares with higher value (but they don’t receive any cash). Overall, there is no change in underlying value, just a change in the mix of shareholders.
Vartika Gupta is a solution manager in McKinsey’s New York office, where David Kohn is an associate partner; Tim Koller is a partner in the Denver office; and Werner Rehm is a partner in the New Jersey office.
For a full discussion of market dynamics, see Valuation: Measuring and Managing the Value of Companies, seventh edition (John Wiley & Sons, 2020), by Marc Goedhart, Tim Koller, and David Wessels.